I Worry Much Less About the Reality than About the Reactions

by Don Boudreaux on January 28, 2008

in Current Affairs, Economics, Myths and Fallacies, Regulation

Brian Wesbury, writing in today’s Wall Street Journal, offers excellent reasons why the anxiety over the current state of the economy is overblown.  Here are some key paragraphs:

Beneath every dollar of counterparty risk, and every
swap, derivative, or leveraged loan, is a real economic asset. The only
way credit troubles could spread to take down the entire system is if
the economy completely fell apart. And that only happens when
government policy goes wildly off track.

In the Great Depression, the Federal Reserve allowed
the money supply to collapse by 25%, which caused a dangerous
deflation. In turn, this deflation caused massive bank failures. The
Smoot-Hawley Tariff Act of 1930, Herbert Hoover’s tax hike passed in
1932, and then FDR’s alphabet soup of new agencies, regulations and
anticapitalist government activity provided the coup de grace. No
wonder thousands of banks failed and unemployment ballooned to 20%.

But in the U.S. today, the Federal Reserve is
extremely accommodative. Not only is the federal funds rate well below
the trend in nominal GDP growth, but real interest rates are low and
getting lower. In addition, gold prices have almost quadrupled during
the past six years, while the consumer price index rose more than 4%
last year.

These monetary conditions are not conducive to a
collapse of credit markets and financial institutions. Any financial
institution that goes under does so because of its own mistakes, not
because money was too tight. Trade protectionism has not become a
reality, and while tax hikes have been proposed, Congress has been
unable to push one through.

Which brings up an interesting thought: If the U.S.
financial system is really as fragile as many people say, why should we
go to such lengths to save it? If a $100 billion, or even $300 billion,
loss in the subprime loan world can cause the entire system to
collapse, maybe we should be working hard to build a better system that
is stronger and more reliable.

Pumping massive amounts of liquidity into the economy
and pumping up government spending by giving money away through rebates
may create more problems than it helps to solve. Kicking the can down
the road is not a positive policy.

The irony is almost too much to take. Yesterday
everyone was worried about excessive consumer spending, a lack of
saving, exploding debt levels, and federal budget deficits. Today, our
government is doing just about everything in its power to help
consumers borrow more at low rates, while it is running up the budget
deficit to get people to spend more. This is the tyranny of the urgent
in an election year and it’s the development that investors should
really worry about. It reads just like the 1970s.

The good news is that the U.S. financial system is not
as fragile as many pundits suggest. Nor is the economy showing anything
other than normal signs of stress. Assuming a 1.5% annualized growth
rate in the fourth quarter, real GDP will have grown by 2.8% in the
year ending in December 2007 and 3.2% in the second half during the
height of the so-called credit crunch. Initial unemployment claims, a
very consistent canary in the coal mine for recessions, are nowhere
near a level of concern.

I would add that one major cause of the collapse of so many U.S. banks during the Great Depression was the fact that branch banking in the U.S. was highly restricted.  This restriction on branch banking (1) denied banks the opportunity to diversify their operations geographically.  (See, for example, this paper by my GMU colleague Carlos Ramirez.)  (Also, Canada, which had no restrictions on bank branching, suffered, I think, only one bank failure during the Depression.), and/or (2) reduces competition among banks, thus making them less efficient.

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{ 9 comments }

Steven Horwitz January 28, 2008 at 8:52 am

Yup, only one Canadian bank failed from the early 20s through the Depression and that was before the Depression itself. Many closed *branches* during the Depression, which is surely inconvenient but does not cause the loss of depositor funds the way a bank *failing* does. Folks might also see this Horwitz and Selgin piece from over 20 years ago that addresses some of these issues.

muirgeo January 28, 2008 at 9:09 am

Isn't this statement;

"Pumping massive amounts of liquidity into the economy and pumping up government spending by giving money away through rebates may create more problems than it helps to solve."

…the reason this statement;

"Beneath every dollar of counterparty risk, and every swap, derivative, or leveraged loan, is a real economic asset."

is not true?

Per Kurowski January 28, 2008 at 9:19 am

BRIAN WESBURY says: “Beneath every dollar of counterparty risk, and every swap, derivative, or leveraged loan, is a real economic asset. The only way credit troubles could spread to take down the entire system is if the economy completely fell apart.”

Absolutely not! We have a world of virtual betting out there. In fact one million persons could be betting on the price of one single asset going up against one million of people betting that the price would go down…two million of bets on one little single asset.

Ah, then you might think this is a zero sum game where gains cancel out the losses and nothing happens.

Absolutely not! First the croupier has been milking the players on both sides with immense fees and secondly and more important many of the winners have already left the table substituted by new players with no capacity to pay for the gains of the other, which is what is known as counterparty risk.

BRIAN WESBURY says: “And that only happens when government policy goes wildly off track.”

Precisely, but government policies went off track long ago; with liquidity injections and the appointment of the credit rating agencies as supreme financial overseers.

We do not need a fiscal stimulus so much as we need a real confidence booster; and which does never come from holding out that all is well and dandy!

BRIAN WESBURY says: I would add that one major cause of the collapse of so many U.S. banks during the Great Depression was the fact that branch banking in the U.S. was highly restricted.

The first bank to collapse because of the sub-prime mortgages was a bank in Germany!

tw January 28, 2008 at 9:46 am

Don,

I agree with the general premise of the article, but what about inflation?

Based on the numbers that came out for the most recent tracking period, shouldn't we worry about that reality? Isn't it a reality that we actually don't seem to be reacting to?

FreedomLover January 28, 2008 at 8:57 pm

The collective insanity of the American people should never be underestimated.

Phuong Tran February 19, 2008 at 10:00 pm

When the Great Depression happened, people panic. The Federal Reserve wasn’t prepared for this. Money supply dropped, runs on the banks, and banks failed because people try to get money out at the same time. People did not have enough money to continue what they are buying at the old price, but panics did not last long because correction kicked in and prices dropped. People buy as much as they can before. I’m glad the Great Depression happened in the early 1900s then today because the Federal Reserve is now prepared to prevent something like the Great Depression to occur again, I hope.

I recently attended Dr. Dwight Lee’s speech. What I learned about Dr. Dwight Lee’s speech is how the government is trying to do good for the economy, but instead making the economy worse because they don’t think far ahead of what will happen if things occur such as inflation. The government is trying to pump up the economy by giving money away through rebates to get people to spend more, but doesn’t understand it’s really reducing spending when inflation happens or when people save their money. Me personally, I don’t care if the economy is going down or up. I’m just glad my pocket is going to get fatter. Whether inflation occurs or if I save my money on future use, the money comes in handy and I’m glad the government is giving us extra money to spend. What do you think will happen to the economy after rebate checks get mail out?

lmclane February 19, 2008 at 11:36 pm

“Society Faces a Short-Run Trade-off between Inflation and Unemployment it.” In chapter 1 of the Ten Principles of Economics Gregory Mankiw states, “Increasing the amount of money in the economy stimulates the overall level of spending and thus demands for goods and services. Higher demand may over time cause firms to raise their prices, but in the meantime, it also encourages them to increase the quantity of goods and services to hire more workers. More hiring means lower employment” (pg 13).

To Don Boudreaux,

Do you think this idea of his can relate to this topic? What is your perspective on Mankiw's statement above?

"Increasing the amount of money in the economy stimulates the overall level of spending."
Do you think this is what is happening to the economy?
But if this is happening is it actually hurting the economy because people are worried and are trying to save money now by not spending it?

Margaret T Nguyen February 21, 2008 at 3:59 am

The Great Depression was a horrible event that had happened in the 1900s. Today, we may go through another one. Heck, we're already in a recession as we speak!

I recently attended a conference with Dr. Dwight Lee. I learned a great deal on the Great Depression and the economy. After attending the conference and hearing about Dr. Dwight Lee lecture about the economy and the Great Depression, I started to read more about the economy and what is happening in out world and around the world.
Dr. Dwight Lee mention Milton Friedman and how he wanted to change the world. Friendman believed that money was far more important when he attended the University of Chicago in 1946. Friedman stated that if the income increases then the savings would go up as well, which troubled the government since the government couldn't come up with enough demand.

My question for you, Don, is if you were back in the 1900s and was in the Federal Reserves, what would you have done to avoid the Great Depression. What would you do today to avoid a recession?

-Margaret Nguyen

krista pappas May 3, 2008 at 6:28 pm

I agree with this topic completely. The Great Depression was something that at that time no one was prepared for. And since then our government has made policies and programs to prevent such a terrible thing from happening again.It's not always the greatest idea for our government to get involved with the economy but it is inevitable. They have ways of controlling the money supply and as consumers what we have a demand for.The Federal Reserve is the main reason why the great depression will not happen again in our economy. They have monetary and contractionary policies that help to control the amount of money that is in the economy and as consumers it influences us with how much we want to spend or how much we think we should spend. Now you have to be careful because if the government increases taxes and decreases the money supply we would have some major problems that would lead to massive unemployment. Im just glad that it seems like they are intelligent people looking out for any such problems that the government might create if they are not careful. And right now there is a trend in the nominal GDP growth. And the institutions that might be affected or fail is due to mistakes they have made in their actions. And i do agree that the economy is experiencing a minor recession I even hate to call it that but we are not in any danger of falling into a deep recession or depression. There will always be hard times with the economy but with the policies we have we have ways of getting out of those times.

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